Here's the issue. Can the Fed raise rates? In the old days there were $50 billion of reserves that did not pay interest. The Fed raised rates, so the story goes, by reducing the supply of reserves. Banks needed reserves in proportion to deposits, so they offered higher rates to borrow reserves.

Now, there are about $3 trillion of reserves, far more than banks need, and reserves pay interest. They are investments, equivalent to short-term Treasuries. If the Fed reduce their quantity by anything less than about $2,950 trillion, banks won't start paying or demanding higher interest. And the Fed is not planning to reduce the supply of reserves at all. It's going to leave them outstanding and pay higher interest on reserves.

But why should that rise transfer to other rates? Suppose you decide that the minimum wage is too low, so you pay your gardener $50 per hour. Your gardener is happy. But that won't raise wages at McDonalds and Walmart to $50. This is what the Fed is worried about -- that it might end up paying interest to banks, but other interest rates don't follow.

In my analysis of this issue, it will work, gardener story aside ("Monetary Policy with Interest on Reserves." Ungated here). Banks should compete for deposits, driving up deposit rates. And deposits should compete with money market funds and Treasuries, driving up those rates. More deeply, central banks already seemed to raise rates more by "open mouth operations" than by actually buying and selling things. They say rates should go up 25 bp, rates rise. That experience is likely to continue.

But "compete" and "banks" don't necessarily sit well in the same sentence anymore, and just why open-mouth operations worked so well is a bit of a mystery. In the past there was some sort of credible threat to do something if rates did not go up.

So you can see why the Fed is worried. What if the Fed announces the long-awaited interest rate rise, the Fed starts paying banks 50 bp on reserves and.. nothing happens. Deposit rates stay at zero, treasury rates stay at zero. Congress notices "the Fed paying big banks billions of dollars to sit on money and not lend it out to needy businesses and households." Mostly foreign big banks by the way. Nightmare scenario for the Fed.

Enter ON RRP. It's a natural idea. If the Fed raises interest on reserves, and banks just eat the profits, then the Fed can counter by offering reserves to other investors. A money market fund, say, earning 0 on treasury bills, would jump at the chance to earn 50 bp on reserves. In turn, as more money funds do this, dumping treasuries, Treasury rates must rise. A rush of depositors to the money market funds forces banks to raise deposit rates and then lending rates.

This is, in a nutshell the ON RRP idea. I'm a big fan. I think a large balance sheet open to all is a great thing for financial stability, opening up narrow banking. (More in "Toward a run free financial system.")

You can see why big banks might not be fans. If they can pay 0 for deposits and earn 50bp in reserves, why undermine the profits with competition?

You can also see from my story, that if the ON RRP facility is important for transmitting higher interest on reserves to other assets, the Fed might need to do a lot of it. A lot. We're trying to raise the interest on Treasuries, Agencies, commercial paper, etc. etc. etc. by having money market funds attempt to sell those and hold reserves. They might buy a lot of reserves before rates are equalized.

The total quantity of reserves need not change, and won't if the Fed does no open market operations. But the money market funds will get bank depositors to send them reserves, pay higher interest, and park those reserves at the Fed. Basically the ON RRP will facilitate a big shift of reserves and deposits to money market funds -- if the banks don't raise deposit rates pronto. But that shift could be huge. Did I mention that banks might not like this?

This is Big Stuff for monetary policy. Whether the overnight rate inches up 25 bp in summer or fall is angels dancing on heads of pins. The shift to an interest rate target on a huge balance sheet is a night and day change. And it had better work.

The FOMC minutes

With that background, maybe the whole section on "liftoff tools" makes more sense. So, the Fed opens up reserves to one and all, and stands ready to take trillions. What's the problem?

A couple of participants expressed continued concerns about the potential risks to financial stability associated with a large ON RRP facility and the possible effect of such a facility on patterns of financial intermediation.

I don't get this at all. I gather the story is something like, if interest paying reserves are available, then funds might in a new crisis want to dump all their assets and move to interest paying reserves. But they can just as well dump assets and buy cash or treasuries too. The existence of interest paying reserves open to non-bank institutions just makes very little difference.

It seems to me exactly the opposite. Every dollar invested in interest-paying reserves at the Fed is a dollar not invested in run-prone, financial-crisis-prone, overnight private lending, like the overnight paper Lehman was using at 30:1 leverage the night before it failed. More ON RRP means more financial stability.

If anyone knows a coherent explanation of how offering the most perfect narrow banking in the world (interest paying reserves backed by Treasuries) is bad for financial stability, I'd like to hear it. Are there speeches or papers by the "participants" I don't know about?

You can see the nervousness all over the discussion

Moreover, some participants were concerned that a decision to allow a temporary increase in the maximum size of the ON RRP facility could be viewed by market participants as a signal that a large ON RRP facility would be maintained for a longer period than those participants deemed appropriate.

OK, maybe as an emergency tool to help "liftoff," but they want a promise it ends soon.

While acknowledging these concerns, many participants believed that a temporarily elevated cap on the ON RRP operations at a time when the Committee saw conditions as appropriate to begin normalization would likely pose limited risks; another participant judged that an ON RRP program was, in any case, unlikely to materially increase the risks to financial stability. Some participants noted that a relatively high cap could be established and then reduced fairly soon after the initial policy firming if it was determined that it was not needed, and that such a reduction could help underscore the Committee's intent to use such a facility only to the extent necessary. A number of participants emphasized that the Committee should develop plans to ensure that such a facility is temporary and that it can be phased out once it is no longer needed to help control the federal funds rate.

You can see a big fundamental argument here, and the natural compromises such an argument leads to. OK, just this time. But promise it's limited. Impose a cap.

Alas, this is a lot like promising ahead of time that you won't send ground troops to a war. Just what happens when, the Fed raises interest on reserves to 50 bp., deposits and treasuries don't budge overnight RRP demand hits the cap immediately. And now what, ladies and gentlemen? "Well, we wanted to raise rates, but we hit a self-imposed cap, so I guess that's it for now?"

You will not lower the oceans with an eyedropper. Pegging prices with a cap on quantities is a dangerous affair. Ask the Swiss National Bank. If Mario Draghi had said "we'll do what it takes to save Greece and Italy, up to a cap" do you think it would have worked?

Here you see a huge divide, unlike anything involving the path of rates. (Members seem to pretty much agree on the rules of that game, just differing in their assessment of inflation vs. output dangers.)

The committee goes on to Term RRP, i.e. letting money market funds invest in interest-paying reserves but only for fixed time periods, like a CD. I presume they hope that might equalize rates without "financial stability concerns." But again, I can't figure out what these "financial stability" concerns are, so it's hard to evaluate. But you can see it again as a compromise.

Bottom line, if a bit repetitive. What are the "financial stability" concerns? Or are they really "bank profitability" concerns? Or are they "unwarranted Congressional attention" concerns? (If you think "the Fed is paying banks not to lend" is bad, wait until "the Fed is paying money market funds not to invest" hits the airwaves.)

A few other thoughts.

Reading the report, I was unaware how much foreign currency intervention the Fed does. I'm interested in knowledgeable commentary.

On the whole when-do-we-raise-rates thing, the Fed is clearly in a bit of a pickle. We all know that stable expectations, transparency, etc. are good things, and that the Fed should not induce volatility by adding uncertainty about interest rate movements. So, Ben Bernanke started an admirable effort to give "forward guidance" about what the Fed would do. As the time to raise rates comes nearer, the Yellen Fed has sensibly wanted to telegraph "data-dependent" decisions. Even John Taylor would cheer at that, as "data dependent" is the heart of the Taylor Rule.

But the Fed also wanted to maintain its "flexibility." And without a Rule, "data dependent" looks to markets a lot like "whim-dependent." Without a rule, the "data" can be "we changed our mind."

So bit by bit, good intention by good intention, the Fed finds itself back in the corner that markets are parsing tiny differences in phrasing -- will She say that soon she might moderate "patience" to "tolerance?" FOMC members are arguing it out in speeches, and the Fed ends up creating more volatility than reducing it.

Source: Torsten Slok

I'm soon going to be nostalgic for the zero bound. It had a great advantage -- everyone knew exactly what interest rates were going to be! The neo-Fisherite prediction of gently declining inflation was bearing out.

Mary Kissel asked me if I thought raising rates now is a good idea, so the Fed has some room to lower them later. I fumbled a bit, with an analogy that it's like wearing tight shoes because it feels good to take them off.

It's a good and deep question, asked by many, and I see that sort of opinion from many Fed-watchers: Raise now so we have room to stimulate if something goes wrong.

That view embodies a nonlinear or state-dependent idea of how monetary policy works. "Stimulus" is not just the level of the rate, but the rate relative to recent history. So, a zero rate in the crisis of 2018 is more effective if it has been preceded by tightening than if not. It's certainly possible, if rates push around some slow-moving state variable. If someone holds this view and can name the state variable I'd like to hear it.

Mary also asked if I thought the Fed was "politicized" when I opined they were worried about Congressional attention above and beyond economic issues. I fumbled a bit. A perfectly a-political agency would be nuts not to consider how its actions might or might not attract attention from Congress. And that's how it should be in a democracy. Congress should pay more attention to many agencies, both sides respecting the trade of independence for limited powers. In this case, I agree that Congress may misunderstand perfectly good ideas -- paying interest on reserves, that the interest comes from Treasuries so is a wash to the taxpayer -- but that raises the onus on the Fed to explain these simple concepts so Congress and the rest of us understand what they're up to. Eschewing good economic policy because one worries Congress can't understand it is a bad way to run things.

A last thought: If the US's main economic problem, and financial markets' main shock, is whether the overnight federal funds rates rises by 0.25 percentage point, in the context of a slowly improving real economy and very low inflation, there to sit another 6 months to a year, this will be great news. The world is blowing up, Russia is invading Ukraine, Greece could go under, bond markets could go haywire. Look to the variance, not the mean. How the Fed will react to a big shock is far more important than what they will do in a perpetually quiet world. There will be more shocks!

Don't you think the Fed is too obsessed with interest rates? It's not part of their mandate to smooth out interest rates. It's a means to an end, yet they seem to be treating it as a competing objective. Hence all the blather about "we have to start raising rates now, since we can only raise by 0.25% every 6 months". It's ridiculous.

John -- There is a recent FEDS working paper by Lorie Logan, Antoine Martin, and others that attempts to illustrate some financial stability concerns. The analysis is imperfect (all amalysis is), and, if I recall, relies on the interaction of limits on the sise of ON RRP (one may disagree with such limits) and possible sharp shits away from assets like private CP (such sharp shifts would not occur with a very large ON RRP, where private money was largely displaced, but may occur if the ON RRP is too small to displace private money)

I'd love to know the real answer from people inside the Fed. Guessing, I'd say first that the Fed has always been a bank to banks. It only lent to banks and only took deposits from banks. IOR in the form of interest paying deposits at the Fed for everyone, circumventing banks entirely, would be a big step. ON RRP looks like repo transactions which the Fed is already doing. Why anyone needs collateral from the Fed is another curiosity of this arrangement. Still, this is just a guess and I would be interested to hear from any insiders, to the extent they can comment in public.

I'd love to know the real answer from people inside the Fed. Guessing, I'd say first that the Fed has always been a bank to banks. It only lent to banks and only took deposits from banks. IOR in the form of interest paying deposits at the Fed for everyone, circumventing banks entirely, would be a big step. ON RRP looks like repo transactions which the Fed is already doing. Why anyone needs collateral from the Fed is another curiosity of this arrangement. Still, this is just a guess and I would be interested to hear from any insiders, to the extent they can comment in public.

The collateral taken from the Fed can be lent out. Imagine a primary dealer shorting 10_year Govt bond. It needs to borrow that security to give to the seller. Hence, the dealer would take the proceeds of its short selling, lend it to the Fed secured, and uses the collateral to give to the seller.

So, these RRP are absorbing liquidity without selling the 2,5 trillion securities bought by the and they remain as collateral on the asset side of the balance sheet. The increase in liquidity absorbing Reverse Repos would be reflected only on the liability side of the balance sheet—bank deposits will fall and RR rise by an offsetting amount ?Whereas with an outright sale of a central bank treasury or ABS—the open marketoperation - there is a decline in securities held (asset side) and a decline in bank reserves (liability side)It this is correct in terms of accounting, than with these Reverse Repos basically the FED will borrow (and pay interest accordingly) in place of the FED for the treasuries she bought thanks to QE it and she will do it with the overall (money) market and not only with banks. Let us say that eventually the FED will want to bring rates up to 4% while keeping 2,5 trillions of securities, she will then pay 100 billions in interest every year on what she has on the liability side while on the asset side she will have bonds that pay still 1% or 2% ? If I am not mistaken once you want to raise rates, the debt now bought by the FED with reserves that cost 0,1% will become costly again, it seems. I mean this policy of running a big balance sheet will have a cost over time for the FED balance sheet ?

Here's a facepalm worthy quote from Federal Reserve Bank of St. Louis President James Bullard: http://blogs.wsj.com/economics/2015/02/20/feds-bullard-favors-banishing-patient-stance/?mod=blogmod

"Mr. Bullard said his preferred way of raising rates would be to boost the rate the Fed pays banks for reserves to 0.50%, while lifting the rate offered on reverse repurchase agreements to 0.25%, with the overnight fed funds rate target trading between those two points."

Get it? He wants the Fed to pay above-market rates on reserves - deliberately lose money - even after introducing the technical means to borrow at the lowest cost. After all, they've been giving away money to banks for 6 years, can't stop now. Risks to financial stability!

If they are going to pull this crap, I'd rather they just increased required reserves. By tweaking RR they can pull interest rates up to, or above, interest on reserves. And it's a power they've always had, nothing new to invent.

The Fed will pay banks more and more interest to do nothing? And then other non-banks (but financial institutions) the same deal? Gee, that's a nice arrangement.

Once banks and non-banks are hooked on earning interest for doing nothing, and the Fed raises rates, says to 3%, what are the odds rates could ever be cut?

I have other concerns, the same when I review the horrendously complicated US tax code, or the welter of welfare programs: Is this transparent? Does the public understand what is going on? Does it pass the KISS test? Od do some of complications smell of obfuscation?

If the Fed wants to tighten monetary policy, why can it not just sell from its balance sheet and also raise rates the old-fashioned way?

If we are suspicious of regulatory capture in so many other regards, or the potential for it, why are we not suspicious in this regard?

I think this is one of the strongest arguments in the Fed for selling off the balance sheet and going back to the old ways. Which, if you may recall, had their own problems. The Fed, largely populated by honest public servants, does not want to be seen as "paying taxpayer money to banks" even though that's a fallacy and it's just a conduit for Treasury interest that would get paid anyway. Which is, for once, too bad, since a large balance sheet has many economic benefits.

There is a meaningful difference between RRP and reserves which you may want to explain.

Reserves at the Fed are unsecured deposits by the participating banks -- they just deposit money at the Fed and earn 25bp. Part of it is due to their requirements and part of it is that 25bp is a good rate to get!

On the other hand, RRP is a secured financing between the Fed and the Primary dealers. That is the Fed adjust the money flow by borrowing and lending using US. Govt paper as collateral. Primary dealers can borrow money or collateral secured from the Fed to finance their trading operations. By raising the rates on RRP, it will be make it more expensive for the primary dealers to borrow money from the Fed to fund trading government securities. Hence, the dealers are willing to pay higher rates to borrow from money market funds. There has been a conversation to remove this connectivity and allow other investors directly do RRP with the Fed. In that case, Fed will compete directly with its own primary dealers.

What you are suggesting here appears different. You want the Fed to become a bank for other investors. They can just open an account at the Fed and deposit their cash. In that case, banks will need to compete with the Fed!!

It is important to note that while a bank holding company, say JP Morgan, has both a bank (depository institution) and a primary dealer, they are in different legal entities with meaningful restrictions on their connectivity.

At a detail level, I found your October 21 paper hard to read because I lack background. It took me a while to figure out that $E_t$ is an operator that represents the market expectation at time t of whatever's on the right-hand side, which I assume would be obvious to any PhD economist. I know you're not writing it for people without the background... maybe I need to go back to school.

But at a higher level, I also really had trouble with it. In a world where the Fed is able/willing to monetize the debt, present government debt has financial value even if it will never be paid off. Worst case, it just all winds up all owned by the Fed, and, as a bond holder, I get my cash back out plus interest. So, I am immediately suspicious of equation (1). Maybe I'm just an idiot, but I expect the right-hand side of equation (1) to be negative, that is, I expect the Federal debt will never be paid off, yet I still believe that Federal debt has value.

Then, in Section 5.3 ("Big Picture"), you write about three theories of why fiat money has value. You argue that with non-scarce fiat money, the quantity theory falls apart. I don't get it. Money may not be scarce for the ultra-wealthy, but it's scarce for most of us. Even with $4T in reservers, US dollars are scarce from a practical viewpoint, for the 99% or even 99.9%, even if the total quantity out there is much much more than is needed for day-to-day transactions, sitting idly in the bank accounts of enormous corporations, soverign wealth funds, and the ultra-wealthy. The assumption I think most of us are making is that if the ultra-rich ever start to spend all that cash, the Fed will get to work mopping it up by selling off its treasury holdings, preserving the practical scarcity of money in all expected scenarios.

In other words, I see nothing inconsistent between the propositions that "money is valuable because it is uniquely useful in transactions" and "there is an enormous amount of base money sitting in bank accounts of parties disinclined to spend." Scary, maybe. Inconsistent, no.

For me, that line raises the most interesting and important question from your paper. WHO is holding large US dollar deposits in foreign banks and WHY? Those excess reserves are a new phenomenon and big enough to move the global capital market so someone should ask where they come from and why. Why are the depositors of those funds (who are presumably "foreign") not investing those funds somewhere in the world? Are there institutional reasons favoring a passive bank deposit going to the US over capital investment somewhere in the world?

The answer is simple: raise the amount of zero interest yielding reserves from the $50bn that JC cites at the start of his article to the somewhere near the $3tr he cites. That should get commercial banks competing for reserves and paying a decent rate of interest to obtain same. Or have I missed something?

On reflection, I am unconvinced that the IOR really is an interest rate. An interest rate is a required rate of return necessary to create demand for a security. It is not possible to issue debt securities without offering the required rate of return. Reserves, by contrast, are created at will by the Fed. "Interest" is not required. Therefore reserves are qualitatively distinct from government debt or any other interest bearing asset. John's analysis confirms this: the IOR is a transfer payment. Now, we can choose who receives the transfer, and the amount paid may influence what banks charge on deposits and loans, but given that the stock of reserves is fixed and all that changes if the IOR is raise is that money gets remitted from the Fed to banks, rather than from the Fed to Treasury, I am unconvinced that anything else will change significantly. The transmission mechanism may be unorthodox: ie banks "collude" in raising rates in step with the IOR ...

This post below higher up, but the system seems to foil replies to replies.

BTW, I think the Fed having a large balance sheet is fine. It could be even larger, I think. I like the idea that interest flows back into the Treasury, helping reduce burdens on taxpayers (don't tell Congress, they will raise spending).

Yet QE in Japan, and the U.S. has not yet resulted in inflation that you can notice.

I do question the Fed payment of IoER. Maybe it has been necessary to prevent an old-fashioned demand-pull inflation, If so, we are miles from that. Why not cut IoER by one basis point a month and see what happens?

Anyway, I think the problem for the foreseeable future is not inflation or higher interest rates, but deflation, dead interest rates and weak aggregate demand.

I keep thinking that John Cochrane is a smart guy, but barking up the wrong tree.

How can we use monetary policy to boost aggregate demand, in this time and place? How about steady QE at $50 bil a month, and cut IoER by a basis point a month?

Benjamin, You ask " How about steady QE at $50 bil a month...? There's a potential problem there which is that if QE is on a big enough scale and goes on for long enough, the state ends up owning all assets (including your house and car). However, Scott Sumner seems quite happy with the latter outcome which to my mind proves he's lost contact with reality.

Good grief Ralph, Scott doesn't want the government to own all assets. His point is that when people claim the Fed is "impotent" and "out of ammunition" at the ZLB, those people are not thinking clearly.

You make the same mistake that people make regarding Keynes' comments about the long run, or about burying bottles of bank notes in mines. Those are thought experiments meant to stimulate thinking, not policy advocacy.

Ralph Musgrave: I think Sumner's point is QE has to be stimulative, not inert or deflationary, at some point.BTW Japan may monetize its national debt in another 10 years or so. I think the Swiss National Bank could monetize tax receipts for years...and declare tax holidays...Interesting times....

First, why not allow the public to hold reserves? IOR-paying reserves remain exclusively in the banking system, but give account holders the option to exit zero-yielding demand deposits and compete for these higher-yielding reserves. They could not be spent into the nominal economy, of course, but could serve as your yield hike vector. This would also allow the public to "collateralize" their own bank exposure on demand -- in effect, take away reserves from safe banks, add reserves to dodgy banks -- all wonderful and desirable, no?

Second, I'm baffled as to why we are having a tightening debate. What exactly has changed in the Fed's mandate that made a crisis of 3-4% nominal growth during 2001-2002 and 1991, and yet 3-4% is perfectly acceptable, too fast even, today?

The Fed does not buy Treasuries from commercial banks! They buy from what we used to call brokerage houses, or broker-dealers.

Now, the primary dealers do not have $3 trillion of Treasuries in inventory to sell to Fed QE.

So they went out and bought Treasuries on the market, and funneled those Treasuries back to the Fed.

The sellers of those Treasuries to the primary dealers either banked their money, or consumed it, or re-invested it in other bonds, equities or property.

Now Cochrane makes the leap that the increases in deposits and related reserves at commercial banks is "banks swapping one asset for another."

That is not a complete picture. At the same time as QE was going on, households and corporations were building up piles of deposits at banks. There may be sizable amounts of foreign flight capital too.

So, the increase in reserves had multiple fathers, not just QE.

And that means QE was stimulative, in the manner desired: That is, sellers of Treasuries went out and spent their money or reinvested it. A large portion did end up in banks, inert. But not all it.

I think the "banks just swapped Treasuries for reserves" narrative developed after the "we will die in hyperinflation" arguments evaporated. The "right wing" can't stand the fact that QE worked, and there really is no inflation to show for it. We are in the part of the curve where more money in circulation means greater output.

To have full allotment RRP you need LOLR for shadow banks. Carney thinks a good idea, US Congress, less so. Also, SEC regulates money funds. Adding $3 trn in assets to money funds doesn't seem like a good idea if you don't regulate them and just lived through five years of the SEC ignoring your request to eliminate fixed NAVs. It is wonderful that we have market based credit in the US and a central bank built for the panic of 1907.

It seems the concerns about Reverse Repos come from *if* the financial system enters a stressful period as opposed to ON RRPs *causing* a rupture. After initially reading your post I was assuming those concerned with financial stability were focused on the latter but it seems to be the former per the link

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.

About Me and This Blog

This is a blog of news, views, and commentary, from a humorous free-market point of view. After one too many rants at the dinner table, my kids called me "the grumpy economist," and hence this blog and its title.
In real life I'm a Senior Fellow of the Hoover Institution at Stanford. I was formerly a professor at the University of Chicago Booth School of Business. I'm also an adjunct scholar of the Cato Institute. I'm not really grumpy by the way!